ZURICH, Sept 3 (Reuters) - The Swiss central bank is
determined to defend its currency cap as a rise in the franc
would pose a major threat to the economy, the bank's head said
on Monday, as data showed the country's manufacturing sector
contracted more sharply in August.

The bank set a cap of 1.20 per euro on the franc almost
exactly a year ago, citing a risk of deflation and a recession
as investors seeking sanctuary from the euro zone crisis pushed
the Swiss currency up sharply.

"In the current situation, a further appreciation of the
Swiss franc would constitute a very substantial threat to the
Swiss economy, and would carry with it the risk of deflationary
developments," Swiss National Bank Chairman Thomas Jordan said
in a speech.

"With this in mind, we will continue to enforce the minimum
exchange rate with the utmost determination, in line with our
mandate."

Monday's purchasing managers' index reading supported
Jordan's warning, showing a manufacturing slump deepened last
month, contrasting with a more upbeat outlook from the leading
KOF indicator last week.

"The SNB has no reason to change its policy," said Julius
Baer economist Janwillem Acket.

The PMI index fell to a seasonally adjusted 46.7 points from
48.6 points in July. The print, missing analysts' forecasts for
49 points, was the fifth in a row below the 50 point mark that
separates growth from contraction.

"In view of the roller-coaster ride in Europe, Swiss
industry is failing to pick up," said index compilers Credit
Suisse and the SVME purchasing managers' association.

"The creeping downturn in industrial activity should
therefore continue in the months to come, especially since the
backlog of orders is continuing to trend downwards."

FOREX RESERVES BALLOON

Analysts tend to watch Swiss economic data closely to see if
it continues to support the case for the cap, which the SNB is
having to defend with heavy interventions. Its foreign currency
reserves hit nearly 70 percent of gross domestic product in
July.

The amount of cash commercial banks hold with the SNB rose
to a new high last week, figures showed on Monday, but the pace
of the increase slowed, suggesting the central bank did not
intervene as much last month as in July.

Asked in an electronic poll if they thought the SNB could
sustain the cap, 66 percent of the participants at the financial
conference where Jordan was speaking said "yes".

Figures showing how much the SNB's foreign exchange reserves
increased in August are due out later in the week, while data on
second-quarter GDP growth is due on Tuesday and August consumer
prices are out on Wednesday.

"It is too early to talk of an all-clear. The economy has
probably lost significant dynamism in the second quarter
already," said Bernd Hartmann, head of investment research at VP
Bank. "A renewed escalation of the (euro) debt crisis would also
have serious consequences for the Swiss economy."

Julius Baer economist Acket said the main reason for the
discrepancy between the PMI survey and the more upbeat KOF
indicator was that the former reflected sentiment at hard-hit
small and medium-sized manufacturers.

"We are in a kind of split economy, with the metalworking,
machinery and investment goods industry suffering from the
European contagion, while services - and even tourism - are not
doing so badly despite the high exchange rate," he said.

In his speech, Jordan reiterated concern about strong rises
in Swiss real estate prices in recent years, partly fuelled by
the low interest rates the SNB has been forced to maintain to
stop the franc from soaring.

"The risk of a further build-up of imbalances followed by a
significant price correction is still present," he said.

In July, new rules to constrain risky lending by banks were
enacted. Yet due to signs of a cooling of the property market,
the SNB has decided for now to forego forcing banks to boost
their capital via a buffer.
(Reporting by Catherine Bosley; Editing by Andrew Heavens, John
Stonestreet)